On January 7, 2013, the United States Court of Appeals for the Second Circuit declined to take an expansive reading of Section 16(b) of the Securities Exchange Act of 1934 (as amended, the “Act”) in Gibbons v. Malone1, ruling that an insider’s profits are not recoverable under that provision when the insider2 sells shares of one series of registered common stock of a company and purchases shares of a different series of registered common stock of the same company.

Under Section 16(b) of the Act, an insider of an issuer with equity securities registered under Section 12 of the Act must disgorge profits to that issuer realized “from any purchase and sale, or any sale and purchase, of any equity security of the issuer … within any period of less than six months.”3 Such profits are often referred to as “short-swing profits.” Lawsuits to recover short-swing profits may be brought by the issuer or by any stockholder of the issuer in the name and on behalf of the issuer.

The facts in Gibbons are straightforward and uncontested. Between December 4, 2008 and December 17, 2008, John Malone, a director and large shareholder of Discovery Communications, Inc. (“Discovery”), engaged in nine sales of Discovery’s Series C common stock and ten purchases of its Series A common stock. Each of the Series A common stock and the Series C common stock was registered under Section 12(b) of the Act, and thus each was an “equity security of the issuer” for purposes of Section 16(b) of the Act. After Discovery declined to seek recovery of short-swing profits from Malone, Michael Gibbons, a Discovery stockholder, brought suit under Section 16(b) of the Act seeking disgorgement of profits from Malone. Gibbons alleged that Malone profited by more than $300,000.00 from these transactions.

As noted above, Discovery’s Series A and Series C common stock are separately registered and traded on the NASDAQ stock exchange under different ticker symbols. The Series A stock comes with voting rights, but the Series C stock does not. Neither stock is convertible into the other. The Series A and Series C stock are entitled to almost the same dividend and liquidation rights4, and the trading prices of the two series were alleged to be highly correlated. However, the correlation was not perfect as the Series A stock had closing prices on the nine relevant dates that varied between approximately four to eight percent higher than the Series C stock.

The United States District Court for the Southern District of New York5 dismissed Gibbons’ complaint, finding that it failed to state a viable Section 16(b) disgorgement claim. The District Court focused on the phrase “any equity security” in the statutory text, and interpreted such phrase to refer to purchases and sales of one equity security, not various equity securities. The District Court also distinguished the stock at hand from other financial instruments that are treated as functionally equivalent under Section 16(b)6 since, unlike such other financial instruments, the Series A and Series C stock of Discovery are not convertible and do not have a fixed value relative to each other. As a matter of policy, the District Court noted that it was “unpersuaded by Plaintiff’s policy arguments regarding the likelihood that ‘[p]ermitting short-swing trading between voting and non-voting common stock would make evasion of Section 16 trivially easy.’”7

On appeal, the Second Circuit affirmed the ruling by the District Court. The Second Circuit first examined the statutory text, noting that the statute imposes a form of strict liability on insiders and “‘operates mechanically, with no required showing of intent.’”8 The Second Circuit noted its agreement with the explanation by the District Court that the reference of “any equity security” as opposed to “any equity securities” in Section 16(b) supports an inference that the “purchase and sale” or “sale and purchase” must both be directed to the same equity security. The Second Circuit noted that it has been its longstanding view that, although Section 16(b) might be read literally to allow recovery where one class of stock is purchased and a different class of stock was sold, the likelihood that this was the intent of Congress is “beyond the realm of judicial fantasy.”9

On appeal, Gibbons also argued that the Series A common stock and the Series C common stock are “the same security” for purposes of the short-swing profit rule because those types of stock are “economically equivalent.” The Second Circuit decided that, although Section 16(b) could apply to transactions where the securities at issue are not “meaningfully distinguishable,” the Series A and Series C stocks in fact were “readily distinguishable” since, most importantly, the Series A shares confer voting rights whereas the Series C shares do not. Further, the Second Circuit noted that the “economic equivalence” principle was developed in the context of fixed-ratio convertible instruments whereas the securities at issue in this case were nonconvertible securities.

The Court also noted that the fact that the two securities' prices fluctuate relative to one another does not qualify them as “economically equivalent,”10 and that, therefore, plaintiff was asking the Second Circuit to “enter uncharted territory by holding that the two securities are sufficiently ‘similar’ to be paired under § 16(b).” The Second Circuit declined to adopt an approach absent support from the SEC. It noted that, firstly, the statutory text seems to require sameness, not similarity, and, secondly (from a policy perspective), Congress intended for the Section 16(b) to be an “arbitrary rule capable of easy administration” and therefore one in which can be mechanically applied.11

The Second Circuit concluded by holding that an insider’s purchase and sale of shares of different registered equity securities of the same issuer does not trigger liability under Section 16(b) of the Act where those securities have different voting rights, are traded separately and are nonconvertible.

In conclusion, the Second Circuit in Gibbons has strongly indicated that Section 16(b) should be interpreted by a straightforward reading of the statutory text and the related policy underpinnings, taking into account the fact that the statute is strict liability as well as the need for administrative ease. The Second Circuit was unwilling to look beyond the statutory text and existing regulations, venturing into uncharted territory, in making its decision but noted that it would be willing to consider future guidance by the SEC.